Explain why low-income households have limited liability in credit markets

Economics by Geoffrey

Format: Please typewrite your answers and show all your work when making calculations. You can make calculations by hand and add the images to the document but make sure to typewrite your answers (you can use this Word document). Remember to submit to Canvas before 2:30 pm on the due date.

 

 

  1. [70 pts] Credit
    1. [10 pts] Explain why low-income households have limited liability in credit markets

 

 

 

  1. [5 pts] Name two important consequences that result from limited liability and asymmetric information in the credit market

 

 

 

 

  1. [5 pts] Using the two terms you listed in part b above, categorize the following as being examples of either one, the other, or neither:

 

  1. Choosing a high value, but risky agricultural project

 

  1. Only individuals wanting to invest on projects that offer high reward, but low probability of success are the ones seeking loans

 

 

  • Planting diversified crops that will succeed in many types of weather

 

  1. Using credit to plant crops in low-lying flood-prone land (i.e., very likely to lose the crop)

 

  1. Taking credit to smooth consumption after an income shock

 

  1. [10 pts] Describe what feature of microfinance overcomes the two challenges you listed in part b above and how it achieves this result

 

 

 

  1. [20 pts] Imagine an area that has one dominant industry of cassava growing. Cassava is a low-risk crop that has an 80% chance of having a good harvest, giving a farmer an income of US $100 and a 20% chance of a poor harvest giving a farmer US $0. Buying cassava clippings that are necessary for planting costs the farmer US $50.

 

  1. [5 pts] What are the expected profits of growing cassava?

 

10 pts] Suppose some households do not have any assets or cash necessary to pay the $50 to cover the cost for the clippings to planting cassava, what is the maximum interest rate a farmer will be willing to pay a bank for a loan that covers the cost of planting if they have limited liability?

 

 

[5 pts] Would a lender be willing to lend at this interest rate?

 

[20 pts] Now imagine that Nestle opens a chocolate factory nearby and has demand for cocoa. In addition to growing cassava, farmers now have a choice to plant cocoa for US $50. However, cocoa is a sensitive crop, and so it fails with a 70% chance (giving the farmer zero) and succeeds the other 30% where the farmer can sell the crop to Nestle for US $150.

 

 

  1. [5 pts] What are the expected profits of growing cocoa without a loan? Given this result, what crop will the farmers choose to plant?

[10 pts] For households that need to borrow to make the planting investment, what is the maximum interest rate they are willing to pay now that they have these two investment options (and given they maintain limited liability)? Which investment option will they choose if the bank offered the maximum interest rate you calculated in part e)?

[5 pts] Is the bank willing to lend to borrowers now that Nestle has opened their factory?

[30 pts] Savings and Insurance

 

  1. [10 pts] List and describe three possible explanations for the observed low savings rate in low-income countries

 

 

  1. [10 pts] Which explanation did Jakiela and Ozier investigate in their 2015 paper? What were their conclusions about whether this factor matters?

 

 

 

  1. [5 pts] Why could index-based insurance schemes work where other insurance schemes fail?

 

[5 pts] How does mobile money and digital credit can help to improve risk-sharing in small communities lacking access to insurance companies?